Roth IRAs: we know ‘em, we love ‘em. Who can argue with tax-free growth and tax-free withdrawals for the rest of your life? Of course, the problem is getting your money in there in the first place.
If you’re above the Roth IRA contribution income limit, you won’t be able to make an annual contribution. However, there’s still another option available: the backdoor Roth IRA contribution. This is where you make an annual non-deductible traditional IRA contribution – up to $6,000 in 2022 plus another $1,000 if you’re 50 or older – and then subsequently convert that amount to your Roth IRA.
The backdoor Roth IRA contribution has been a solid retirement planning tactic for years now.
However, when dealing with taxes, there are always rules that can come back to bite you. Backdoor Roth IRA contributions are no exception.
Today, I’m going to discuss two rules for backdoor Roth IRA contributions and how to avoid making mistakes that can cost you thousands. And be sure to read until the very end where I share a key component to this strategy that many people – even CPAs – forget.
The IRA Aggregation Rule
Internal Revenue Code Section 408(d)(2) requires taxpayers to aggregate their IRAs for tax purposes. What does this mean in English? If you have multiple IRA accounts, the IRS considers all those separate IRAs as one account for tax purposes.
To be clear, different types and differently titled IRA accounts aren’t aggregated. You wouldn’t include your spouse’s IRA, your Roth IRA, or an inherited IRA with your traditional IRA accounts for aggregation purposes.
However, you do have to include SEP IRAs and SIMPLE IRAs in the total.
How does this aggregation complicate a backdoor Roth contribution? One word: deductibility.
Let’s say, years ago, you rolled an old employer 401(k) into an IRA. Now, those assets are worth $94,000.
In your excitement to begin annual backdoor Roth IRA contributions, you’ve also funded a new and separate traditional IRA account with $6,000 in nondeductible contributions.
Because of the account aggregation rule, the IRS considers your two IRAs as one account for tax purposes, totaling $100,000 – $6,000 being nondeductible contributions.
So, what happens when you try to make a Roth IRA conversion on the $6,000 in your second IRA? Unfortunately, part of it is subject to income tax.
Because the accounts are aggregated, only the pro-rata share of non-deductible IRA assets would be considered a non-taxable Roth IRA conversion.
In this case, only 6% of the conversion ($6,000 / $100,000) would be non-taxable.
So instead of a properly executed backdoor Roth IRA conversion, only $360 would be converted without taxes. You’d owe ordinary income taxes on the remaining $5,640!
That’s not the result we’re looking for.
So, how do you avoid this mistake? Well, simply knowing about the IRA account aggregation rule helps. If you have multiple IRAs, annual backdoor Roth IRA contributions may not be a tactic that’s available to you.
However, if you have IRA assets and a decent employer retirement plan, you might have an option. You may want to consider rolling your IRA in to your active 401(k) plan if it accepts roll-in contributions. 401(k)s have different rules and are not included in IRA account aggregation.
Strangely, after-tax, non-deductible IRA assets are not allowed to be rolled into an employer retirement plan under Section 408(d)(3)(A)(ii). So, the IRA account aggregation rules don’t apply in this case.
An exception to a tax law? That’s unpossible!
Once you’ve moved your IRA into your 401(k), the backdoor Roth IRA contribution strategy is back on the menu.
However, there’s another rule that could come up to bite you…
The Step Transaction Doctrine
The step transaction doctrine essentially treats a series of discrete “steps” as a single transaction if, taken together, the steps are intended to produce a particular result.
Because a backdoor Roth IRA contribution has multiple steps focused on a particular result, it could potentially be considered a “step transaction” and disallowed by the IRS. If you’re considering funding your Roth IRA in this manner, there are some best practices that you should follow.
First, allow time to pass between each step in the process. You could always buy your target investments with the non-deductible IRA contributions and convert them in-kind. Independently, each of these steps is permissible, so the goal is to establish that each step really is separate.
Unfortunately, there are no rules on how long to wait between transactions. Somewhere between a month and a year should work, depending on how conservative you want to be with this strategy. Some tax experts stand by the “one statement rule” – if you wait at least long enough to get a new monthly statement from your account you’ll be okay.
In addition, if you invest the funds between steps, there’s a chance that you’ll create a small tax liability when you convert. For instance, if your $6,000 grows to $6,500, the $500 in gains will be taxable when you convert. A little growth isn’t bad – and it could also be used to prove that it wasn’t a “step transaction”.
Second, do not keep notes about using backdoor Roth IRA contributions or discuss it in written communication with your financial advisor or CPA. This kind of communication is discoverable and could potentially be used against you in tax court!
Avoiding Backdoor Roth IRA Mistakes
If you’re making a backdoor Roth IRA contribution this year, be sure to get your professionals involved early. If you wait until late December, you may not be able to get it done in time. The big account custodians and brokerage houses have started closing the window on year-end transactions earlier and earlier over the last few years.
Finally, there’s one more mistake to avoid when making backdoor Roth IRA contributions: forgetting to file Form 8606. Form 8606 specifies that your initial IRA contribution was indeed non-deductible, and therefore your subsequent Roth IRA conversion was non-taxable.
Where I see this issue come up the most is when someone does all this work themselves – and then forgets to tell their CPA about the non-deductible contribution. It’s an easy one to forget!
If you need help planning your retirement tax strategy, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.